Corporate Governance Failures: The Role of Institutional Investors in the Global Financial Crisis

9 The Sophisticated Investor and the Global Financial Crisis

C h a p t e r 9 The Sophisticated Investor and the Global Financial Crisis Jennifer S. Taub We want the sophisticated investor to protect himself, but we also want a system that identifies crooks and comes down like the wrath of God on them. We need both. —Charles Munger, vice chairman of Berkshire Hathaway And here I think what's intriguing is we have a failure of both. —Joseph Grundfest, Stanford Law School professor Introduction The financial instruments and risky practices that caused the global financial crisis of 2008 were enabled by decades of deregulation and anemic government enforcement efforts. The elements that combined to create the crisis were subprime mortgage securities, credit default swaps, highly leveraged hedge funds, and excessive short-term borrowing at investment banks.1 They flourished without government oversight, transparency, or limits because proponents contended that ‘‘private ordering’’ of financial markets, instead of government intervention, was ideal. The champions of private ordering contended government interference was inappropriate for The Sophisticated Investor and the Global Crisis 189 sophisticated investors (SIs) who had the expertise and incentives to properly assess risk, and to select and monitor complex investment options. They believed that by acting in their own interests, SIs would keep the market safe and ensure the efficient allocation of capital to businesses and individuals who would make the most productive use of the money. Sophisticated investors include, for example, government, corporate, and union pension funds, mutual funds, hedge funds, endowments, brokerdealers , insurance firms, banks, and sovereign funds. They also include individuals who earn as little as $200,000 per year. While many experts warned about the dangerous consequences of deregulation,2 Congress and regulators accepted the conventional perspective that sophisticated market participants would police and avoid irrational conduct.3 The concept of the SI exception is embedded in our securities laws. It is a mechanism that allows securities issuers to sometimes bypass legal requirements intended to protect ordinary people who purchase securities (‘‘retail investors’’). The securities laws were designed, initially, to protect retail investors from confusing, worthless, or high-risk investments.4 In other words, ‘‘Congress was concerned that the average investor was being fleeced in the financial markets by inadequate disclosure, misrepresentation , and manipulative schemes.’’5 Thus, once an investor is deemed ‘‘sophisticated ,’’ many investment options can be offered and sold without many protections.6 The demarcation between the ordinary and the sophisticated , as noted below, depends wholly upon wealth and not upon any measure of experience or skill. The SI concept spread to other financial laws and rules. And when new risky instruments emerged, the reliance upon a market filled with SIs was sufficient to convince lawmakers and regulators to remove barriers and allow for the expansion of these unregulated or very lightly regulated offerings. The SI exception may have been a valid carve-out to the early legal requirements from the 1930s. However, a few major changes make it no longer viable. First, unlike earlier securities offerings, financial instruments have grown far more complex than the capacity of computers to handle, let alone human brains. Some computer scientists and economists argue that ‘‘even when buyers know all of the relevant information,’’ it is nearly impossible to price even the simplest collateralized debt obligations7 and that it would take many days for a powerful computer to establish a price.8 As a result, mere humans, including most expert analysts, got lost in the complexity, fell prey to decision-making biases, and overlooked the absence 190 Jennifer S. Taub of critical data points.9 In the debt and derivative markets, many of these tradable instruments did not exist in the 1930s, nor did they exist even prior to the 1980s or 1990s. Indeed, even those who constructed these instruments admitted difficulty pricing them. For example, a Goldman Sachs employee who helped build and sell such a structure posed this rhetorical question: ‘‘Well, what if we created a ‘thing,’ which has no purpose, which is absolutely conceptual and highly theoretical and which nobody knows how to price?’’10 Second, the incentive to maximize short-term personal welfare meant ‘‘sophistication’’ in forecasting and preventing the demise of one’s firm and the financial system as a whole was subordinated to short-term profit seeking by senior executives and other employees. Thus, those who expected ‘‘self-interest’’ to prevail forgot the agency problem—that personal selfinterest is not the same as...